Category: investing

Generals charge ahead while soldiers in full retreat

Friday was a remarkable day for students of the market’s internal strength, aka “market breadth.”  The Nasdaq 100 (NDX), powered by a 16% surge in Google, was up 1.45% even though declining stocks outnumbered advancing stocks by 50.  This has never happened on a day the NDX gained over 1%, not even close.  According to Jason Goepfert of SentimenTrader, breadth was negative only three other times in history.  One of those days was March 23, 2000 – right at the top of the Nasdaq bubble!

Year-to-date, the Wilshire 5000 (a measure of market capitalization of 5000 companies) has added $751 billion in market cap, a 3.5% gain.  By our measure, 10 companies have accounted for $471 billion, or 63% of those gains.  The top 5 have a combined market cap of $1.489 trillion – 6.6% of the Wilshire 5000 – and accounted for 52% of the ytd gains.

  • Apple: $113 billion, +18.4% ytd
  • Google: $107 billion, +31.8%
  • $81 billion, +55.6%
  • Facebook: $48 billion, +21.7%
  • Gilead Sciences: $38 billion, +25.9%
  • Netflix: $29 billion, +135.2%
  • Celgene: $18 billion, +20.3%
  • Biogen: $15 billion, +19.2%
  • Regeneron Pharmaceuticals: $15 billion, +34.5%
  • Tesla Motors: $7 billion, +23.5%

Further, biotechnology stocks make up 3% of the S&P 500 by market cap yet account for 15% of the year’s gains.  Meanwhile, the Dow Jones Transportation and Utility Averages are 12.5% and 11.9% below their 52 week highs respectively, even though the Dow Jones Industrials Average is within 1.4% of an all-time high.

As legendary market watcher Bob Farrell warned, narrowing leadership is typical of the late stages of a bull market.  This phenomenon is even more pronounced during the blowoff stage of a financial bubble.  We call this the “casino effect.”  Gamblers, addicted to winning over a long period, refuse to leave the casino even though several tables are coming up snake eyes.  Instead they gravitate to the diminishing number of winning tables.  Regarding the stock market, this is a classic sign of denial.  The losing tables are in essence early warning signs, stocks succumbing to deteriorating economic fundamentals.  Yet speculators ignore the red lights and fail to connect the increasingly obvious dots.  At the end the investing crowd feels it is in control and their favorite stocks are immune to macro factors.

Apple is a good example.  In Q1, China revenue grew 71% and accounted for 29% of the total.  At what point do the troubles in China affect Apple, the beloved stock of retail investors and the biggest weighting in index funds?  We could get some clues this Tuesday after the close when they report Q2 earnings.


Peak profits, stock prices?

Recently a respected colleague said our strategy was rational but markets, and the world for that matter, were highly irrational.  After participating in financial markets for the last 25 years I thought my experiences allowed me to see it all-wrong!  So after reflecting on our irrational state of affairs the logical side compiled some of the glaring data sets signifying a massive market top. 

First, a chart created by John Hussman ( indicates how much excess we’ve witnessed in corporate profitability vs GDP lately.  Keep in mind his data includes financials which to this day remain a subsidized black box.  (Click on image to enlarge).New Picture (1)

Of course this hasn’t stopped wall street from expecting further net margin expansion:


Profit margin growth

Before Wall Street follows Congress out the door for the holidays maybe they should scrutinize this:

profits vs labor

To derive this unprecedented profit picture both consumers and government went on a spending binge.  US national debt, through 5 years of record deficits, added almost $7.7 trillion to our balance sheet-can you say malinvestment?personal savings govt deficits profits


Now, if we remove the creators of financial alchemy we notice the real economy topped many quarters ago. 


Nonfinl corp profits

So if you care to break away from CNBS and look at the graphs above rational behavior would suggest profit taking and or short exposure.  In fact, it was just 7 years ago that many of these same signals were sent to the market yet we were labeled as the boys crying wolf.  If your timing is perfect the crowd labels you a genius but too early, a chump. 



Delusions of optimism

The cover of this week’s Barron’s refers to an article on page 7 with the tease, “Bullish news: Fear is rampant.” The author, Jonathan Laing, cites a report put out by James Paulsen, Wells Capital Management’s strategist and long-time talking head on CNBC:

Also bullish is the fact that investor sentiment is in the dumpster. [Paulsen] calls it “dominance of doubt.” Investors put little trust in bullish developments such as the much-maligned economic green shoots, the sharp narrowing in the yields of all manner of fixed-income instruments over Treasuries, or even corporations reporting better-than-anticipated earnings. This psychology could lead to huge upside price potential in stocks once the bears become converted, he argues.

Leaving aside Paulsen’s credentials as a perma-bull who failed to see the greatest economic crisis since the Great Depression coming, the evidence of bearishness appears thin. For starters, Newsweek declared on the cover of a recent issue, “The Recession is Over!” The “VIX,” a measure of expected volatility (referred to as the “fear gauge”) hit a low of 23.09 on July 24. This was the lowest reading since September 8, 2008 when the S&P 500 stood at 1268, right before plunging 37% in 2 1/2 months. The Investors Intelligence poll, which showed 47.2% of newsletter advisers bearish in early March, is now down to just 26.4% bears. Similarly, the Consensus Inc. survey showed just 18% bulls at the March low vs. 51% today.

Our favorite sentiment indicator is still the asset mix of Rydex bull and bear funds. Currently just 26.4% of the assets in these “directional” funds are betting on the downside. At the height of the credit bubble the lowest bearishness reading was 30.8% on October 31, 2007. At the time the S&P 500 stood at 1549; yesterday’s close was 1006. For perspective, at the March 9, 2009 bottom (S&P 500 at 677), 52.0% of the assets in Rydex’s timing funds were positioned for a further decline.

Contrary to the claims of the bulls, there is no “dominance of doubt,” just a preponderance of delusion.

Note: The Fund’s equity short position was 136% on September 8, 2008, 21% at the beginning of this year, 2% at the March 9 low, and 67% as of yesterday’s close.

Slope of Hope springs eternal

Hope springs eternal with regards to government attempts to re-create the bubble economy of 2003-2007. Since August 17, 2007, when the Bernanke Fed first began cutting rates, the bubbleonians have bought into every announced intervention. The lessons of the past 20 years were clear: when the Fed turns the lights green, put the pedal to the metal. When that advice failed, the Paulson Treasury came in with the message, “we have your back.” $700 billion blank checks for Wall Street? Buy stocks!

Three weeks ago, after 1 1/2 years of pumping massive doses of “liquidity” into a lifeless corpse, investors were beginning to accept that the plug would be pulled. Among the assets in Rydex bull and bear funds, 54% were betting on further declines. Then the patient’s finger twitched. The Fed hatched a scheme to buy long-term bonds with printed money (so-called “quantitative easing”) and Treasury announced a “public-private partnership” to buy toxic assets from zombie banks so they could lend again (with the taxpayer taking on 85% of the risk, of course). Investors, with visions of the Steven Seagal character in “Hard to Kill,” rallied the S&P 500 25% off its intraday low. At Rydex, just 39% of market timing assets are now in the bear camp. The Slope of Hope is on the mend.

In the Bearing Fund, we came into March with an equity position of 14% net short. On March 9, with the S&P at 677, we took that down to 2%. (See our post about the case for being market neutral.) As of yesterday, with the S&P at 832, we were net short over 16%.

AIG: America’s Insolvent Guarantor

Since the Fall of 2008 the US government has committed over $11 trillion in new credit and or credit backstops to prevent the collapse of our modern day banking system. Closer examination of various TARP and other bailout recipients reveal the extraordinary demands of American International Group (AIG) which after Monday surpassed the $173 billion level. Hard to imagine when AIG had assured shareholders just one year ago that “excess capital was $14.5-19.5 billion”. At the same time we were commenting on how credit default swaps would follow sub prime lending as disaster du jour with AIG leading the charge. Of course as a taxpayer and reluctant current shareholder of AIG I have to ask how did we get here and how high does this bailout number get over the next several years?

If we rewind the tape back to the Summer of 2007 most market participants envied AIG, the world’s largest insurance company. How could you not after hearing statements like this from one of their top brass:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

~ Joseph J. Cassano, a former A.I.G. executive, August 2007

Just 12 months later the shadow banking system was imploding and former Treasury secretary Hank Paulson called Goldman CEO Lloyd Blankfein and several other counterparties to discuss implications of AIG’s swap exposure. Unbeknown to many at the time was Goldman’s counterparty importance to AIG, specifically both credit default and interest rate swap exposure. Unfortunately 70% of the derivative market trades under-the-counter so specifics on CDS and interest rate swaps is difficult to decipher, until now. After reporting a quarterly loss of $61 billion last week, the largest quarterly loss in U.S. history, AIG’s largest shareholders demanded details on where the bailout money was dispersed. The list of culprits comes as no surprise.

Goldman Sachs Group Inc and a parade of European banks were the major beneficiaries of $93 billion in payments from AIG — more than half of the U.S. taxpayer money spent to rescue the massive insurer. Revelations that billions of U.S. taxpayer dollars were funneled through AIG to Goldman Sachs — one of Wall Street’s most politically connected firms — and to European banks including Deutsche Bank, France’s Societe Generale and the UK’s Barclays could stoke further outrage at the entire U.S. bank bailout.

It doesn’t to me seem fair that the American taxpayer has got to bear the 100 percent of the downside,” said Campbell Harvey, a finance professor at Duke University. “A hedge is not a hedge if you did not factor in the counterparty risk. And the U.S. taxpayer should not be obligated to make people whole for hedges that were not properly executed.”

My Comments: In a little over 12 months the largest insurer in the world has now become part of the zombie gang joining other former leveraged high fliers such as Citigroup, Fannie Mae and Freddie Mac. Latest disclosure documents from AIG put potential CDS exposure north of $500 billion. When adding interest rate swap exposure to the mix the total derivative book exceeded $1.5 trillion! Are derivatives becoming a problem now that the asset inflation game has come to a grinding halt? Citibank, Bank of America , HSBC Bank USA , Wells Fargo Bank and J.P. Morgan Chase reported that their “current” net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31, 2008 . Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

As the shell game continues we get closer to the real players in this collapsing fraud, primarily the insolvent TARP recipients who require yet another open ended capital conduit. Is it any surprise that the AIG bailout money flows through to politically connected zombies such as Goldman, Merrill (now Bank of America) and Deutsche Bank? Or that Bernanke makes a 60 Minutes infomercial Sunday night assuring the American people that money center banks will not fail based on his “new”reflation experiment?

Finally, we look at the Obama administration where Turbo Tax Timmy Geithner is assigned to the AIG bonus scandal hoping the distraction preoccupies most of main street. Unfortunately this too shall backfire since many of these potential bonus recipients know where all of the counterparty skeletons reside in this open ended bailout sham. Note to the administration: Be careful what you wish for.

The case for market neutrality

We are currently torn. The portraits of risk and opportunity, as viewed through the three lenses of economics, valuation, and sentiment, are unusually blurred. The economic landscape is ablaze, with government spraying gasoline through their various hoses of zero interest rates, bailouts, and stimulus. The valuation setting is tranquil and serene, with prices for high quality companies at some of the most enticing levels of the past two decades. The sentiment picture is in the grey area, with obvious signs of despair, yet still more room for panic, capitulation, and pitch black.

All in all, we believe a compelling case can be made for a market neutral position.

… more later.

End-of-year portfolio allocation

The case for optimism

Was this morning’s 200 point selloff the final capitulation, at least for the intermediate-term? No one knows, but we were buyers. What we do know is there are many great companies and valuable assets selling at the most reasonable prices we’ve seen since at least the mid-1990s.

There is a dichotomy taking place between long-term survivors and economic roadkill. In the latter column we find most of the “too big to fail” politically-connected financial sector. We remain short the “Chosen Ones” begging for a life preserver: Goldman Sachs, JPMorgan Chase, Citigroup, Bank of America, et al. We continue to mostly avoid consumer discretionary and luxury goods purveyors.

Our buy list has several characteristics:

  • companies providing necessities, e.g. food and energy
  • resource-based companies
  • solid balance sheets, high cash levels
  • high barriers to entry
  • ability to remain profitable and perhaps even grow in a difficult environment
  • providers of value-oriented products, e.g. discount retailers
  • global consumer brands
  • cheap valuations, high margin of safety

Besides cheap valuations, a second reason for optimism is that the political class is feeling real pain, despite fleecing the taxpayer to cover its gambling debts. Citigroup stock broke $5 today, down from a high of $55. Saudi Prince Alwaleed is buying the dip. The self-professed “Warren Buffett of the Middle East” is in denial. His beloved Citigroup, the foundation of his reputation, is insolvent. Our hope is that the curtain is finally being pulled back on these “Masters of the Universe.” What happens to the “Goldman effect,” where every key cabinet position goes to a former employee of Goldman, if the company turns into Enron times 100? Without question this would be bullish long-term for the country.

Of course, the case for pessimism remains: decades of fiat money, moral hazard, and social engineering created an epic mess, made worse by government hampering the healthy corrective process. The financial elites have done irreparable damage to the economy, yet the public continues to allow them to operate their wrecking ball… at least for now.

The chess game continues…

Since we began maintaining this blog 14 months ago, we’ve focused on three themes:

  1. Government intervention is toxic.
  2. Intervention is driven by the schemers and dreamers. The schemers – political capitalists like the big banks and investment banks – leverage themselves to perpetual asset inflation. As their bet turns sour, friends in high places intervene on their behalf.
  3. This intervention, unlike the experience of the past 20 years, does not reflate the asset balloon. In fact, it is utterly doomed to failure. (Note: The Fed has expanded its balance sheet by $637 billion, or 74%, the past 12 months, yet residential real estate lost roughly $4 trillion in value and the stock market shed over $6 trillion.)

This Greek tragedy has unfolded in several phases.

  • Phase 1: An epic credit bubble begins to burst.
  • Phase 2: Speculators refuse to leave the casino, emboldened by government attempts to keep the party going. They simply move from the financial craps table to emerging market poker and commodity roulette.
  • Phase 3: Speculators go into full blown panic mode as they realize all the monetary tea in China can not save them. The overextended are taken out of the casino in bodybags while their facilitators counterfeit wager chips on a massive scale.

As we move well into Phase 3, what is the appropriate strategy for protecting wealth? On the one hand, every multi-billion dollar intervention is like sticking a needle into a voodoo doll of the economy. On the other hand, inflation hedges are on sale. For example:

  • The 30-year T-bond yields 3.97% and the Bullish Consensus is up to 69%. We remain short and shorting rallies.
  • Gold briefly dropped below $700/oz. today, more than 30% below highs set last March. We own and continue to buy physical gold held in the vault of the oldest private bank in Switzerland.
  • Gold stocks (as measured by the “XAU“) are 67% below their highs. We hold a significant stake (roughly 11%) and continue to buy on weakness.
  • Commodity-related stocks have been decimated with fertilizer stocks more than 70% off their June highs, the Natural Gas Index (XNG) 49% off its peak, and the Oil Index (XOI) 48% below its top. Even with crude oil cut in half to below $70/bbl, oil and gas stocks reflect significantly lower prices. We have built a significant position in ag/energy (roughly 9% in fertilizer, seeds, coal, oil and gas, uranium) while hedging somewhat with crude oil (1.7%) and grain shorts (1.5%). We are avoiding more economically-sensitive commodities and remain short copper (0.8%).

In order to hedge against our current economic swan dive trajectory, we remain short the credit sector, commercial real estate, and the broad market (though we’ve been covering on weakness).

Do short sellers contribute to panics?

I doubt it, coming from a hedge fund that was heavily net short going into yesterday’s mini-meltdown. While others were panicking, we were buying. (When they rallied the Dow 1,000 points on the initial news of Paulson’s $700 billion bailout scheme, we were selling.)

In fact, it is hard to imagine a professional short seller lasting long in this business by piling on when the market tanks. The Great Bull Market of 1982-2007 made mincemeat of this strategy. And in the past 18 months – generally a rewarding period for short sellers – numerous government interventions, meant to catch speculators off guard, rendered such a strategy suicidal. After 25 years of asset inflation and chronic moral hazard, the dedicated short selling community is all but extinct, making up perhaps 0.1% of all hedge funds. To imply short sellers had anything to do with the implosion of Countrywide, Fannie, Freddie, AIG, Bear, Lehman, et al. is ludicrous. (Yesterday, Wachovia opened down over 80% before those dreaded short sellers were even allowed to place an order.) Let’s not forget, the biggest short seller in the room, Jim Chanos, admitted he missed out on the troubles at Bear Stearns and Lehman Brothers.

The market is a mechanism for price discovery and the short seller provides a vital role in that process. The financial establishment (and their political handlers) bet their livelihoods on perpetually rising prices, thus their incessant attempts to subvert this process, and keep prices of homes, mortgages, and bank stocks elevated. Good luck.

In an article today, Lew Rockwell explained the futility of government trying to prop up prices:

You have to understand how ridiculous this whole debate looks to anyone who understands the price system. Let’s change the example from houses to apples to see how silly it is to suggest that falling prices can be made to rise. Let’s say that the Fed created an apple hysteria that drove the price from $3 per pound to $10. Stores loaded up and even used them as collateral for expansion. Suddenly the price collapsed to $5 and finally to $2.

Now government takes notice. What can government do to deal with the problem? It can try to boost the price of apples by forcing stores to raise their prices. But what about consumers? They won’t buy at $10. So the apples sit and rot. Maybe government should buy them all or force consumers to buy them. Also perhaps stores will just not buy any more at all. Government could force them to. But it can’t force them to stay in business. People can always walk away. So perhaps government can just buy the stores, all in the interest of keeping the price of apples up. But it will have to buy the apple-leveraged stores at a much higher price than the market would offer, so this is a bad economic deal on the face of it.

The tangles can get ever more complicated and billions and trillions can be spent. You can put everyone in a prison camp and force people at the point of a gun to buy and sell apples at $10. But in the end, the problem is still the same: the price of apples wants to fall. Nothing government does changes that one fact. To attempt to change it is like trying to change gravity. Of course, the government’s central bank can raise all prices through inflation to the point that apples do in fact cost $10, but this is purely cosmetic. In fact, in real terms, the price of apples is still $2. It is a pointless and destructive activity to try changing this. You only cause massive damage in the

In fact, as Rockwell points out, lower prices have a cathartic effect:

It is not entirely clear why prices fall. It could be the worldwide economic slowdown. It could be that the markets are beginning to doubt the capacity of the Fed to actually achieve the hyperinflation that it wants, since banks have become quite risk averse. In any case, we need ever-lower prices on all things, including gas and groceries – and, yes, houses. This is the basis for economic recovery.

Just as in the 1930s, the political class is doing its best to thwart the price system. If successful, they will produce similar results… or worse.

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